Students learning economics should also learn history. In particular, it’s important that they are taught that quack international accounting standards exist alongside quack economics. The two tend to go hand in glove because the vested interests often overlap.

One notable example is the increasing move to using “fair value” in bank accounts, a philosophy that means that assets or instruments are recorded in the balance sheet at the price that the company believes they would fetch on the open market rather than the price actually paid. Mark to market is a close cousin, in which assets are priced based on today’s market price.

The approach looks neat and tidy, especially to auditing firms who struggle to define more cautious subjective measures, such as prudence.

But there are two particularly dangerous weaknesses to watch for in fair value accounting standards: false profits and fake capital. Both can appear in the accounts of banks as a result of fair value accounting during a bubble. Worse, prospective losses are excluded from accounts of banks because losses that can be clearly foreseen don’t have to be taken, again giving the appearance of capital that doesn’t exist.

But history here teaches valuable lessons. To be blunt, mark-to-market accounting has been tried before with disastrous results only to end up reinforcing asset price bubbles to the point where they trigger a crisis.
It was mandated in the German Commercial Code as far back as 1861 and a financial bubble developed shortly afterwards. The resulting instability in the newly federated Germany is seen by many as a trigger for the Franco-Prussian War of 1870. The lessons from this helped contribute to subsequent prohibitions in law across Europe.

By the 1920s, the US still used the mark-to-market model in accounting conventions for its banks. They helped to fuel the late 1920s asset price bubble, also known as the Wall Street boom, as the rising value of assets used as security triggered an associated lending bubble.

The first big bank to collapse in December 1930 was the giant Bank of the United States, whose accounting flattered its apparent worth following a series of ambitious takeovers. The collapse followed a run on the bank that destabilised the entire banking system and led to the Great Depression. President Franklin D Roosevelt later took the US banks off the fair value model altogether.

Market negation

Related

Experience tells us the theory of fair value accounting requires the efficient market hypothesis to work. But whether markets are efficient or not, accounting standards provide a means to disrupt the markets. Even if markets were efficient during all periods, mark to market can serve to negate that.

The problem with mark to market is not merely that what has gone up might go down. That is the easy bit. The problem is the system as a whole is prone to behave as if all gains are readily convertible into cash, when they are not and never can be.

Problems become acute when the gross amount of assets in a system marked to market – or worse still, marked to a price generated by a computer model – becomes greater than the amount of cash, credit or equity which is needed to make transactions happen at those prices. Beyond this point, the realisation of unrealised gains becomes an impossibility. In theory, you could raise cash from asset sales, but this practice, if repeated, may well cause other asset prices to collapse.

The fault with mark-to-market accounting is not merely that asset prices might go down, the problem is when a whole system is being ratcheted up to a point where the question of whether asset values might go down becomes a situation where asset values must go down.

When the party presenting the rosy but unreal picture is a limited liability company, one of the most dangerous things that can be done is making distributions to shareholders (dividends, bonuses or buybacks) or taking out borrowings secured on unrealised gains or missing losses.

Tipping point

A tipping point arises when creditors eventually and inevitably realise that their interest is being put at risk by what is little more than equity extraction in disguise. The timing of the first symptoms of a credit crunch in the banking sector in the second quarter of 2007 exactly matches the realisation – through a new disclosure standard SFAS 157 – on this type of accounting.

The right question came from an analyst on a call with Bear Stearns management in April 2007, the year before it collapsed: “You guys are paying yourself on these gains?”

If the term “unrealised gain” is changed to “unfunded gain”, the fundamental problem with the mark-to-market approach becomes even more apparent. It is simply not possible for all parties to realise the gains at that value at that point in time. If a particular idea becomes a bad one, once you study the lessons of its previous applications in history, you may wonder how once more it gets traction in the financial system in the first place.

• Tim Bush is head of governance and financial analysis at shareholder research and advisory consultant PIRC

--This article first appeared in the print edition of Financial News dated January 13, 2014